SEC Adopts Executive Compensation Clawback Rules | Seward & Kissel LLP
On October 26, 2022, the Securities and Exchange Commission (the “SEC”), implementing a requirement of the Dodd-Frank Act, passed a final rule requiring the recovery of wrongfully awarded executive incentive compensation. Rule 10D-1 of the Securities Exchange Act of 1934, as amended (“Rule 10D-1”) directs national securities exchanges and associations to establish listing standards that require a listed issuer to:
- adopt and adhere to a written policy for the recovery of incentive compensation awarded in error received by current or former executive officers in the event that the Issuer is required to prepare an accounting restatement (a “Clawback Policy”); and
- file the recovery policy as an attachment to its annual reports, indicate whether any restatements require recovery analysis, and disclose any actions it has taken under such recoveries.
Each exchange is required to file its proposed listing standards within 90 days of the publication of Rule 10D-1 in the Federal Register, with listing standards to become effective no later than one year after such publication date. Issuers must adopt a clawback policy within 60 days of the effective date of the applicable exchange’s listing standards implementing Rule 10D-1.
- Rule 10D-1 applies to all listed issuers, including foreign private issuers, controlled group companies, junior reporting companies, emerging growth companies, debt issuers and securities companies. business development, as well as registered investment companies (including internally managed ones) that have awarded incentive compensation to any executive officer in the last three fiscal years.
- The recovery policy should seek recovery whenever there is a “Big R” restatement (which restates historical financial statements to correct errors that were material to previously published financial statements, and which requires the filing of a form 4.02 Form 8-K), as well as in the event of a “small r” restatement (which restates errors in a prior period that were not material to the previously published financial statements but that would result in a material misstatement if the errors were not corrected in the current report or the error correction was recognized in the current period).
- The clawback policy must apply to incentive compensation granted during the three-year period prior to the date the issuer concluded (or reasonably should have concluded) that a restatement is necessary, or the date a court or regulator orders the issuer to prepare a restatement.
- The clawback policy must require the clawback of incentive compensation paid in error on the basis of erroneous financial statements of all current and former officers of the issuer, whether or not the officer is responsible for the error, during the three-year look-back period.
Five key components
- Individuals covered. Current and former “executive officers” are subject to the clawback policy. A “senior executive” includes the president, chief financial officer, chief accounting officer of the company, any vice president responsible for a major business unit, division or function, and any other person who exercises policy-making functions for the company (including officers of a parent company or a subsidiary). For a limited partnership, executive officers are officers or employees of the general partner who perform policy-making functions. Rule 10D-1 would not require the recovery of incentive compensation received before such person became an executive officer of the issuer.
- Incentive compensation. “Incentive compensation” means any compensation (including cash and stock) awarded, earned or vested based, in whole or in part, on the achievement of a “financial reporting measure”. “Financial reporting measures” are measures that are determined and presented in accordance with accounting principles used in the preparation of the Company’s financial statements, and any measures derived in whole or in part from these measures, as well as the share price and total shareholder return (“TSR”).
- Receipt of incentive compensation. Incentive compensation is “received,” and therefore subject to clawback, in the fiscal period in which the applicable financial reporting measure is achieved, even if the payment or grant occurs after the end of that period; the date of “receipt” of this remuneration is therefore linked to the satisfaction of the objective of measuring financial information, regardless of the applicable vesting, allocation or payment dates. An award subject to both time-based and performance-based vesting conditions is considered awarded upon satisfaction of the performance measure even if the award continues to be subject to vesting.
- Amount of recovery. The amount of the clawback corresponds to the amount of incentive compensation received by the executive officer in excess of what he would have received if the incentive compensation had been determined on the basis of the restated financial statements. The calculation of erroneously awarded compensation should be calculated on a pre-tax basis.
- Recovery. An issuer should seek to recover compensation awarded in error in accordance with its clawback policy; however, the issuer will not be required to seek recovery if its compensation committee (or, in the absence of a compensation committee, the majority of independent directors on the board) determines that recovery is impractical for any for the following three reasons: (i) the company provides the exchange with documentation showing that it has reasonably attempted to collect, but that the direct expenses paid to third parties to assist in the execution of the collection would exceed the amount to be collected; (ii) in the case of a foreign private issuer, the issuer provides the opinion of an attorney at the exchange that continued collection would violate home country law in effect prior to the date of publication of the Rule 10D 1 in the Federal Register; or (iii) the recovery would come from a tax-qualified pension plan. Additionally, executives cannot be indemnified for amounts recovered under the clawback policy, nor can issuers pay premiums for insurance policies that would cover an executive’s potential liabilities.
Rule 10D-1 does not apply to the following types of problems:
- securities futures products cleared by a registered clearing agency or an exempt clearing agency;
- standardized options issued by a registered clearing house;
- securities issued by a mutual fund; and
- securities issued by a registered investment firm that has not awarded incentive compensation to an executive in the last three years.
New disclosure requirements
- Annual Report. Each listed company must file its clawback policy as an attachment to its annual report on Form 10-K, 20-F, 40-F or N-CSR, as applicable. Rule 10D-1 also requires that information reflecting the information provided in Section 402 (described below) be included in annual reports on Form N-CSR, proxy statements and corporate statements. director election information, on Form 20-F or, if the foreign private issuer chooses to use the registration and reporting forms that US issuers use, on Form 10-K; and on Form 40-F.
- Section 402 disclosures. Section 402 of Regulation SK requires issuers to disclose how they have applied their clawback policies. If, during its most recently completed financial year, the issuer restated its financial statements requiring recovery, or if there was an outstanding recoverable balance related to a prior restatement, the issuer must disclose the following information: (i) the date the Issuer was required to prepare the restatement and the total dollar amount of excess incentive compensation attributable to the restatement (the “recoverable amount”) and a discussion of how the recoverable amount was calculated or, if the recoverable amount has not been determined, an explanation of why it has not been; (ii) if the remuneration is linked to a share price or a measure of TSR, the estimates used to determine the recoverable amount and an explanation of the methodology used for these estimates; (iii) the aggregate dollar amount of all collectible amounts outstanding as of the end of the company’s last fiscal year and recoverable amounts that have been outstanding for more than 180 days from the date the issuer determined the amount due; and (iv) where an impracticability exception is applied, the amount of the Exempt Recoverable Amount for each identified executive and for all executives as a group and a brief description of why the board of directors of the issuer has decided not to pursue recovery.
- Check the boxes for Forms 10-K, 20-F and 40-F. Issuers should indicate by checkboxes on their annual reports whether the financial statements included in the filings reflect a correction of an error from previously issued financial statements and whether those corrections are restatements that require recovery analysis.
Recommended Action Steps for Issuers
There are several steps an issuer should consider taking at this point.
- Identify covered frames. Issuers should identify covered executives in entities and document, in particular, their policymaking commitments.
- Evaluate incentive compensation agreements. Issuers should assess their existing compensation arrangements to determine which, if any, include elements related to financial performance measurement and whether clawback mechanisms are provided for.
- Incorporate clawback provisions into executive incentive compensation agreements. For new arrangements, issuers should incorporate language in the documents providing for clawbacks, to the extent required under applicable law. If necessary, issuers should consider amending their existing incentive compensation plans and/or award agreements to improve the enforceability of their clawback policy once adopted and to allow for clawbacks at future, to the extent necessary under applicable law.
- Start preparing for the additional required disclosure. Issuers should begin the operational readiness that will be necessary to (x) add the required information, which may be determined once exchange listing requirements are finalized and clawback policy is established, (y) disclose necessary recoveries, if any, and (z) collect Recovery Amounts, when and if necessary.
- Governance improvements. Issuers should review governing documents, including bylaws and committee charters, and other statements of board policy or operation, to determine the need to add provisions regarding new clawback requirements and policy implementation procedures. This review may require dialogue with audit and accounting personnel regarding the restatement of the “small r” so that directors can fully understand their obligations.